Isaac Gradman was involved in some of the earliest litigation arising from the subprime mortgage crisis. He received his B.A. in Political and Social Thought with Highest Distinction from UVA, where he was a Jefferson Scholar, an Echols Scholar and a member of the Raven Honor Society. Isaac received his J.D. cum laude from N.Y.U. School of Law, where he was a Dean’s Scholar and a Robert McKay Scholar. He blogs at SubprimeShakeout.com.
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In another sign that the Federal Government is turning its focus towards prosecuting the securitization players who may have contributed to the Mortgage Crisis, the FDIC filed separate lawsuits against LSI Appraisal (available here) and CoreLogic (available here) earlier this month. In the suits, both filed in the Central District of California, the FDIC, as Receiver for Washington Mutual Bank (“WAMU”), accuses vendors with whom WAMU contracted to provide appraisal services with gross negligence, breach of reps and warranties, and other breaches of contract for providing defective and/or inflated appraisals. The FDIC seeks at least $154 million from LSI (and its parent companies, including Lender Processing Services and Fidelity, based on alter ego liability) and at least $129 million from CoreLogic (and its parent companies, including First American Financial, based on alter ego liability).
As we’ve been discussing on The Subprime Shakeout this past month, the U.S. Government has stepped up its efforts to pursue claims against originators, underwriters and other participants in mortgage securitization over irresponsible lending and underwriting practices that led to the largest financial crisis since the Great Depression. This has included the DOJ suing Deutsche Bank over reckless lending and submitting improper loans to the FHA and the SEC subpoenaing records from Credit Suisse and JPMorgan Chase over so-called “double dipping” schemes. The FDIC’s lawsuit is just the latest sign that much more litigation is on the horizon, as it focuses on yet another aspect of the Crisis that is ripe for investigation–appraisal fraud.
Granted, those familiar with the loan repurchase or putback process have long recognized that inflated or otherwise improper appraisals are a major category of rep and warranty violations that are found in subprime and Alt-A loans originated between 2005 and 2007. In fact, David Grais, in his lawsuits on behalf of the Federal Home Loan Banks of San Francisco and Seattle, focused the majority of his allegations against mortgage securitizers on inflated appraisals (ironically, the data Grais used in his complaints was compiled by CoreLogic, which is now one of the subjects of the FDIC’s suits).
Grais likely zeroed in on appraisals in those cases because he was able to evaluate their propriety after the fact using publicly available data, as he had not yet acquired access to the underlying loan files that would have provided more concrete evidence of underwriting deficiences. But, appraisals have been historically a bit squishy and subjective–even using retroactive appraisal tools–and absent evidence of a scheme to inflate a series of comparable properties, it can be difficult to convince a judge or jury that an appraisal that’s, say, 10% higher than you would expect was actually a negligent or defective assessment of value.
The reason that the FDIC/WAMU is likely focusing on this aspect of the underwriting process is because it’s one of the few avenues available to WAMU to recover its losses. Namely, the FDIC is suing over losses associated with loans that it holds on its books, not loans that it sold into securitization. Though the latter would be a much larger set of loans, WAMU no longer holds any ownership interest in those loans, and would not suffer losses on that pool unless and until it (or its new owner, JPMorgan) were forced to repurchase a significant portion of those loans (read: a basis for more lawsuits down the road).
Which brings me to the most interesting aspect of these cases. As I mentioned, the FDIC is only suing these appraisal vendors over the limited number of loans that WAMU still holds on its books. In the case against LSI, the FDIC only reviewed 292 appraisals and is seeking damages with respect to 220 of those (75.3%), for which it claims it found “multiple egregious violations of USPAP and applicable industry standards” (LSI Complaint p. 12). Only 10 out of 292 (3.4%) were found to be fully compliant. Yet, the FDIC notes earlier in that complaint that LSI “provided or approved more than 386,000 appraisals for residential loans that WaMu originated or purchased” (LSI Complaint p. 11).
In the case against CoreLogic, the FDIC says that it reviewed 259 appraisals out of the more than 260,000 that had been provided (CoreLogic Complaint pp. 11-12). Out of those, it found only seven that were fully compliant (2.7%), while 194 (74.9%) contained multiple egregious violations (CoreLogic Complaint p. 12). And it was the 194 egregiously defective appraisals that the FDIC alleges caused over $129 million in damages.
Can you see where I’m going with this? If you assume that the rest of the appraisals looked very similar to those sampled by the FDIC, there’s a ton of potential liability left on the table.
Just for fun, let’s just do some rough, back-of-the-envelope calculations to provide a framework for estimating that potential liability. I will warn you that these numbers are going to be eye-popping, but before you get too excited or jump down my throat, please recognize that, as statisticians will no doubt tell you, there are many reasons why the samples cited in the FDIC’s complaints may not be representative of the overall population. For example, the FDIC may have taken an adverse sample or the average size of the loans WAMU held on its balance sheet may have been significantly greater than the average size of the loans WAMU securitized, meaning they produced higher than average loss severities (and were also more prone to material appraisal inflation). Thus, do not take these numbers as gospel, but merely as an indication of the ballpark size of this potential problem.
With that proviso, let’s project out some of the numbers in the complaints. In the LSI/LPS case, the FDIC alleges that 75% of the appraisals it sampled contained multiple egregious violations of appraisal standards. If we project that number to the total population of 386,000 loans for which LSI/LPS provided appraisal services, that’s 289,500 faulty appraisals. The FDIC also claims it suffered $154 million in losses on the 220 loans with egregiously deficient appraisals, for an average loss severity of $700,000. Multiply 289,500 faulty appraisals by $700,000 in losses per loan and you get a potential liability to LSI/LPS (on just the loans it handled for WAMU) of $202 billion. Even if we cut the percentage of deficient appraisals in half to account for the FDIC’s potential adverse sampling and cut the loss severity in half to account for the fact that the average loss severity was likely much smaller (WAMU may have retained the biggest loans that it could not sell into securitizations), that’s still an outstanding liability of over $50 billion for LSI/LPS.
Do the same math for the CoreLogic case and you get similar results. The FDIC found 74.9% of the loans sampled had egregious appraisal violations, meaning that at least 194,740 of the loans that CoreLogic handled for WAMU may contain similar violations. Since the 194 egregious loans accounted for $129 million in losses according to the Complaint, that’s an average loss severity of $664,948. Using these numbers, CoreLogic thus faces potential liabilities of $129 billion. Even using our very conservative discounting methodology, that’s still over $32 billion in potential liability.
This means that somewhere out there, there are pension funds, mutual funds, insurance funds and other institutional investors who collectively have claims of anywhere from $82 billion to $331 billion against these two vendors of appraisal services with respect to WAMU-originated or securitized loans. For how many other banks did LSI and CoreLogic provide similar services? And how many other appraisal service vendors provided similar services during this time and likely conformed to what appear to have been industry practices of inflating appraisals? The potential liability floating out there on just this appraisal issue alone is astounding, if the FDIC’s numbers are to be believed.
The point of this exercise is not to say that the FDIC necessarily got its numbers right, or even to say that WAMU wasn’t complicit in the industry practice of inflating appraisals. My point is that these suits reveal additional evidence that investors are sitting on massive amounts of potential claims, about which they’re doing next to nothing. Where are the men and women of action amongst institutional money managers (and for that matter, who is John Galt?)? Are they simply passive by nature, and too afraid of getting sued to even peek out from behind the rock? Maybe this is why investors don’t want to reveal their holdings in MBS – they’re afraid that if unions or other organized groups of pensioners realized that their institutional money managers held WAMU MBS and were doing nothing about it, they would sue these managers and/or never run their money through them again.
The better choice, of course, would be to join the Investor Syndicate or one of the other bondholder groups that are primed for action, and then actually support their efforts to go after the participants in the largest Ponzi scheme in history (an upcoming article on TSS will focus on the challenges that these groups have faced in getting their members actually motivated to do something). It seems that these managers should be focused on trying to recover the funds their investments lost for their constituents, rather than just acting to protect their own anonymity and their jobs. If suits like those brought by the FDIC don’t cause institutional money managers to sit up and take notice, we have no other choice but to believe these individuals are highly conflicted and incapable of acting as the fiduciaries they’re supposed to be. Of all the conflicts of interest that have been revealed in the fallout of the Mortgage Crisis, this last conflict would be the most devastating, because it would mean that the securitization participants who were instrumental in causing this crisis, and who were themselves wildly conflicted, will largely be let off the hook by those they harmed the most.
